Kickstarter and the language of risk and reward in social venture funding

Somewhere between reading the excellent "The Funding Gap" and "Measuring Social Value" in this week's assigned readings, I got to thinking of the task social ventures face gaining capitalization and a key question: is the market (read: social innovators and investment community) speaking the same language when it comes to the value proposition of social investments? Keep this question in mind as you read on and let me know what you think.

I believe the communication of risk and reward between social ventures and investors needs significant focus to allow funding methods to bridge the gap.

I will first consider the example of Kickstarter (the prominent "crowdsourced" investment portal that a) connects individual investors with innovators and b) has the potential to be a key source of grassroots start-up capital for social ventures).

Kickstarter: Back to Basics?

Kickstarter has undergone some very relevant turmoil over the past month. Last Thursday, Kickstarter was forced to issue a corporate blog post titled "Kickstarter is not a Store." While the title is rather self-explanatory, the blog post is, in effect, an Ethics 101 corrective on how those seeking funds through Kickstarter should treat their investors. I was rather alarmed by the following excerpt (emphasis in bold is my own):

Creators must talk about "Risks and Challenges"

Today we added a new section to the project page called "Risks and Challenges." All project creators are now required to answer the following question when creating their project:"What are the risks and challenges this project faces, and what qualifies you to overcome them?"

We added the "Risks and Challenges" section to reinforce that creators' projects are in development. Before backing a project, people can judge both the creator's ability to complete their project as promised and whether they feel the creator is being open and honest about the risks and challenges they face.

This is in effect an admission that a portion of Kickstarter's users have engaged potential investors without being transparent about risk. In addition to clarity on risk, Kickstarter also has problems with the reward side of the equation. NPR's Aarti Shahani (for full disclosure, a friend of mine) actually prompted Kickstarter's policy revision by also looking at the expectation of Kickstarter's investing community in an article published on September 3rd. Some excerpts:

One entrepreneur who raised $10 million to build a "smartwatch" that streams email and text messages just missed his first delivery deadline. One of his backers demanded a refund, to no avail.

[That one should sound familiar to the class ... another example:]

Barnett ... decided to pay back 40 of his 500 backers.

"I think it sets a bad precedent," he says. "Once I did that, I could tell that it started creating the impression in some of my backers that they had purchased an item. And I think as Kickstarter grows, there's more and more of an impression that it's just a big store for people to go get deals."

This type of miscommunication between investors and entrepreneurs is nothing unique to Kickstarter. I highlight it to focus on the language of risk and reward and emphasize how the unique nature of social entrepreneurship significantly stresses this communication.

Talking About Risk and Reward in Social Ventures

In traditional investing, risks and rewards are unconsciously balanced against each other. Formalizing this a bit, the investment community looks at Risk/Reward Ratio:


Investing communities differ in how they view this formula. Investors in stocks are best served through diversification - balancing out not only the expected profits and losses, but the probabilities of profit or loss such that a portfolio of stocks yields long run gains.

Venture capitalists do the same, but weight the equation differently. In expectation of a much higher failure rate for the majority of start-ups, venture capitalists are looking for a much more unbalanced Risk/Reward Ratio that has a massive profit if successful and low expected loss. Thus, they can tolerate marginal success probabilities on the whole as long as they pick a few "big winners."

So how do social ventures place more stress on this ratio? They do by adding in social versions of each term (profit/loss). I'd argue the equation changes as follows:

My best guess at the social value ratio balances social benefit with risk to reputation. I realize I may be on shaky ground, but I argue here that the challenge to a social investor is more general than the risk to the society impacted by the innovation. The human cost of a faulty innovation remains the worst aspect of a failed venture, but from the investor's standpoint that failure could impact their ability to ever invest in the field again.

I have also included weighting factors, alpha and beta, to balance the financial and social sides of the equation. In Professor Zak's scenario where traditional and social entrepreneurship eventually converges into the same field, this equation works well: "traditional" investors will approach ventures with an alpha close to 1, beta close to zero, while purely philanthropic sources of funding will reverse the role of alpha and beta.

Finally, to connect this back to our reading: I am making no attempt to quantify social benefit and reputation risk. For me, the previously mentioned article, "Measuring Social Value," was eye opening regarding all the work people have gone to to try to create social analogies to financial metrics of performance. The included chart, "10 Ways to Measure Social Value" does wonders.

So Where's My Watch?

Now that I have completed my foray into pop-economics, I'll return to Kickstarter. What went wrong? Digging a little deeper than "I want my watch, gimme a refund," the unhappy investor missed the fact that he/she was an investor; the denominator of risk was missing from their assessment of the situation. Kickstarter has taken a concrete step to remedy the situation by making risk explicit and turning a transaction that previously seemed like a purchase into an investment. It will be interesting to monitor how this changes their user base.

For social investments, there are even more language questions to answer:

• Is the investor in it for financial gain over social impact (alpha > beta)? Do the different investors set their alpha and beta differently and does this impact how the venture must operate?
• Does the entrepreneur understand that they need to cater to their investor's worry over reputational risk, or are they just focused on potential social good (i.e., their social term in the formula is just a constant, not a ratio)?

Finally, to balance out the critical look at the state of social investment, I point readers to the example of Vinod Khosla, a prominent venture capitalist who is heavily involved in social investments. In his theory about seeking out Black Swans, he points to how - once we have the right language in which to communicate - the traditional investment community can push an explosion of social good through social venture development:

I am only interested in technologies that have a 90% chance of failure but, if they do succeed, would change the infrastructure of society in some radical way... any one of these things is improbable but, if you have enough shots on goal, then it's very likely that something improbable will win.

So back to my initial question: is the market speaking the same language when it comes to the value proposition of social investments or is my take all much ado about nothing?